Active fund managers continue to disappoint

GeorgeSisti

George Sisti, CFP, is a certified financial planner practitioner and the
founder of On Course Financial Planning, a fee-only Registered Investment
Advisor firm. George graduated with a BS in Mathematics from the State
University of New York at Stony Brook in 1971. After graduation, he served 6
years as a pilot in the United States Air Force, based at McChord AFB, WA. In
2013 he retired after a 35-year career as a pilot for a legacy U.S. airline. George established On Course
Financial Planning in 2004 to help families gain the peace of mind that comes
from knowing that they will be able to retire at the time of their choosing and
not have to worry about running out of money in retirement. He has been a member
of the Financial Planning Association since 2004. He can be contacted through
his website: oncoursefp.com

George's
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Proponents of active management claim that stock market volatility creates an ideal playing field for stock fund managers.

Theoretically, gifted managers can identify stocks that will rise in value and shun those that will decline. They can sell stocks in advance of any serious market decline and reenter the market before the rebound, thereby outperforming their benchmark index.

We've heard this malarkey a million times. And because it is so often repeated, it's time to look at three new reports that debunk this long held myth.

Standard & Poor's released its yearend S&P Indices Versus Active Funds (SPIVA) Scorecard that compares the performance of actively managed mutual funds to their benchmark indexes. The SPIVA Scorecard tells a different story than the one voiced by advocates of active management. In 2012, 63% of large-cap domestic funds, 80% of mid-cap funds and 67% of small-cap funds underperformed their S&P benchmark indexes. Two out of three actively managed domestic stock mutual funds underperformed the S&P 1500
SPSUPX, -0.38%
total stock market index last year.

To give credit where credit is due, there were two domestic equity asset classes in which the majority of active managers outperformed their benchmark index last year — large-cap growth funds (54% outperformed) and real estate funds (53% outperformed). In no domestic equity asset class did the majority of active managers outperform their benchmark index for the three years ending December, 2012. For the five years ending December, 2012 the only domestic equity asset class in which the majority of managers beat their benchmark index was large-cap value — 50.2% outperformed.

Unlike passive index investors who remain invested during a bear market, active managers have the opportunity to move to cash and protect shareholders on the downside. They had a great opportunity to provide value in the past five years; which include the financial panic of 2008/2009. Yet according to the SPIVA Scorecard, 75% of large-cap funds, 90% of mid-cap funds, 83% of small-cap funds and 79% of multi-cap funds underperformed their benchmark indexes during the five years ending December 31, 2012.

For the second time since 2000, active managers, as a group, failed to fulfill their promise to protect investors from steep market declines. Unfortunately for investors, the opportunity to outperform stock market indexes does not often translate into reality.

Vanguard published a whitepaper analyzing domestic stock fund performance for the 15 year period 1997 through 2011. Using data supplied by Morningstar, the study reported that 46% of actively managed domestic stock funds outperformed their benchmark index in the five years ending December 31, 2011. But the percentage of winners declined to 32% when we increase the period under study to the prior 10 years and 27% for the full 15 years.

There will be active managers who outperform every year. But you are investing for retirement over a multi-decade timeframe and as the time period increases, the percentage of mutual funds that outperform comparable index funds decreases.

The primary reason that most actively managed funds underperform comparable index funds is that they have higher expenses. According to another Vanguard whitepaper, the average dollar weighted expense ratio for large-cap actively managed domestic stock funds is 0.7% higher than that of comparable index funds. It is 0.8% higher for mid-cap and small-cap funds. These expense ratios do not include the costs of trading.

The turnover ratio of the average actively managed domestic equity fund exceeds 100%. This means that the average fund manager turns over the portfolio in less than a year. A 100% turnover ratio increases the fund's annual expenses by about 1%. You're a long-term investor but your fund manager is making short term trades in an effort to boost returns and increase assets under management. There's a big disconnect here.

Most investors are unaware of the high fatality rate of actively managed funds. Funds that yield poor performance inevitably suffer a loss of assets and are often liquidated or merged into another fund. Of the 5,108 domestic stock funds available to investors on New Year's Day 1997, 2,350 (46%) were merged or liquidated by year-end 2011. The SPIVA report notes that nearly one out of four domestic stock funds was liquidated or merged in the years 2008 through 2012. Liquidation can generate an unwelcome taxable event for shareholders who must also begin searching for a replacement fund manager — a disappointing state of affairs to say the least.

These studies add to the growing body of evidence that confirms the superior long-term performance of passive index investing. I can't imagine why any investor who is aware of the arithmetic of active management and the historical record would choose a different strategy.

But as long as fortunes can be made by obscuring the facts, voices proclaiming the fictional benefits of active management will never be silent.

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